Mundell-Fleming with Stock Market and Endogenous Risk Premium

Abstract

In the textbook Mundell-Fleming analysis of an open economy in the short run interest bearing bonds are the only assets and expectation about exchange rate movements is usually taken to be static. This is not a good description of the Indian economy where capital inflow in recent years has predominantly taken the form of portfolio investment in stocks and it is driven very strongly by expectations of capital gains. The present exercise is a reformulation that departs from the standard model by replacing (a) the home bond by home stock and (b) static expectations by regressive (stabilizing) expectations. Country risk is captured in the standard model through the introduction of risk premium which is taken as an exogenous parameter. We have made the risk premium endogenous by making it dependent on the country’s current account deficit and the government’s budget deficit. These modifications produce some new results that do not hold in the textbook version.

After eliminating r and taking differential we find that: dY/dA = ng/[sgp + f(ip + n)] > 0. An increase in risk premium leads to an increase in output. Higher values of i (the interest elasticity of investment) reduce the positive impact of A on Y, but the impact remains positive.